I will answer your questions in the order in which they appear. I am a licensed attorney with over a dozen years of experience handling matters such as this one. It is a pleasure to assist you today.
1) is this practice illegal? Yes, it is legal, but it is also legally risky for your school for a number of reasons, including but not limited to liability to the children in the event of an accident and even liability for worker's compensation to the teacher if injured as well (arguably).
2) does this practice expose us to legal liability? Absolutely. You have teachers transporting children to school without commercial licenses, for pay and the teachers work for the school. There is a nexus between the teachers and the school. Liability exists not only to the kids but to anyone that the teacher runs into as well suing.
3) should we create a policy to officially ban this practice? In my opinion, yes...or require the teachers to get commercial licenses and sign waiver of responsibility contracts that include indemnification clauses.
4) as opposed to outright banning, can we get parents who choose to use this service to sign a hold-harmless letter in favor of our school? Yes, but that does not protect the school from other drivers suing if they were hit by one of these teachers transporting students.
5) is there any scenario that is acceptable in which teachers would change their driving license class, their vehicle registration classification and their insurance policy type to make this practice legit and eliminate to a high degree our exposure to liability? Yes, as stated above...new license...commercial insurance...waiver of liability and indemnify the school of the school has to pay for their mistake.
6) if the police stopped any of the these teachers transporting our students and somehow found out that they are being driven for a fee and realized that the teachers are doing this using their personal vehicles would they permit them to go on their way? would they arrest them? what is their legal status technically? They would likely issue them a citation and call for a bus to come to the scene to transport the children to school. It is unlikely they would be arrested though.
7) if you recommend creating a policy prohibiting this practice, what is our response towards teachers who are proven to continue transporting our students in violation of our policy? If they continue to do this for pay, and it violates the policy and stance of the school, it should be automatic termination. It is just too risky for a private school from a liability standpoint.
8) would we be allowed to terminate them if we add this option to our policy? Absolutely.
Let me know if you have any other questions or comments.
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Best wishes going forward!